Busch: Chinese Reality Reckoning

On Tuesday, China announced that new loans in July dropped 67% from June to 355.9 billion yuan from 1.53 trillion. This is a major downshift in stimulation for the Chinese economy as authorities are clearly concerned that the lending has been bleeding into speculation in real estate and commodities.

The China economic rebound story has been a major boost to the Pacific Rim countries like South Korea. This has been the major financial recover story since March. The big question is whether the stimulation stimulated domestic demand is self-sustaining.

We may have gotten a glimpse of the answer today. Reuters reports that the Chinese Ministry of Commerce said that the government steps to boost domestic demand cannot be expected in the short term to fully offset the impact of reduced demand for Chinese exports.

"The ministry described the problem of overcapacity in Chinese industry as "pronounced" and said some sectors and companies still faced operational difficulties. "Currently, China's economic recovery trend has become evident, but the global economic outlook is still unclear and China still faces big pressure on declining external demand."

As an example of this weak external demand, China's exports of automobiles plunged 61.9% yoy in July and 26.8% from June. According to the China Association of Automobile Manufacturers (CAAM), the total exports of China-made vehicles in the first seven months stood at 164,800 units, down 60.3% year on year.

Here's the problem: Chinese crude steel production jumped 13 percent to a record 50.7 million metric tons in July, the National Bureau of Statistics. This is the the third consecutive record monthly high, according to Bloomberg data. Also, Chinese imports of iron ore increased 47% yoy in July and 5% from June.

If the Chinese have greatly stimulated domestic demand, this would seem to be a good idea on the surface. However, the Chinese economy is 60% domestic and 40% exports. If the demand for Chinese exports isn't there, then domestic stimulation will lead to a short term increase in production/GDP, but could lead to a massive build up in inventories and downward pressure on prices if global demand doesn't return.

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If global demand returns, then the inventories will be taken down and the situation will not have a major negative consequence. Unfortunately, the markets aren't optimistic. The Shanghai index dropped 4.86% today and is down almost 12% over the last 7 days.

The Chinese central bank has estimated that 20% of the bank loans made this year has gone into equity market speculation. This weakness has led to weakness in the other equity markets as well including the United States. In turn, commodity markets are softening as they perceive the demand from the Chinese for oil and metals (copper especially).

While the high powered, high velocity stimulation via Chinese bank loans is extremely potent, the question remains whether the economic growth can continue without it. More worrisome, what happens if the 20% equity speculation is pulled out of the Chinese stock market? It will have ramifications and reverberations across all markets.

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Andrew Busch

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Andrew B. Buschis Global FX Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece andreach him hereand you can follow him on Twitter athttp://twitter.com/abusch .